China's march up the manufacturing value chain causing angst aplenty

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The China-US Strategic & Economic Dialogue ground through last week with the usual (ie. high) levels of acrimony. Some baby steps forward were achieved, but expectations for major breakthroughs on major initiatives like the Bilateral Investment Treaty are now so low that simply agreeing to continue negotiations generates relief. US Treasury Secretary Jacob Lew complained about the 'corrosive' impact of Chinese overcapacity in steel and aluminium. China's multi-pronged retort, well honed by now, is that it is trying its best, overcapacity exists worldwide, consumers like cheap Chinese products, and American protectionist instincts are 'hyping' the issue.

These arguments all have justification, as do two points made by Beijing's finance minister Lou Jiwei: China is no longer a 'planned economy' and can't order its many private mills and smelters to shut, and his nation is now unfairly criticised for the investment binge that 'saved the world' (and his own nation’s economy) in 2009. Back then, Lou reminds us, the Chinese worker was nominated for Time's Person of the Year.

The problem is that their bosses kept those Chinese workers busy building even more new factories. In the short term this boosted global demand, but more recently the results have manifested in ever-greater supply. China’s smelting capacity in some metals has doubled since 2009. In macroeconomic terms, China's savings ratio hardly fell. Instead, to reduce its current account balance, it piled on domestic investment. Some observers, like the IMF, warned that China's vast structural trade surplus was just hidden temporarily, and would bounce back. Today that prophesy is coming true. In the meantime, China has made extraordinarily impressive progress up the value chain. The impact on world trade patterns will be very different from a decade ago.

Two unrelated events on the other side of the world last week prove the point. In Germany, sportswear maker Adidas announced it was bringing home an athletic shoe factory from China and elsewhere by using robots. Meanwhile, a Chinese appliance maker has moved to increase its shareholding in German robot supplier KUKA from 15% to 30%; possibly enough to secure management control and KUKA's valuable portfolio of intellectual property (it is one of four firms along with ABB, FANUC and Yaskawa dominating industrial robot technology). Beijing has a powerful policy imperative to move into automation, a key element of the emerging 'Fourth Industrial Revolution.' The government has encouraged a highly exuberant program that looks like it could become a 'robot bubble'. China's ambition has moved from making shoes, to investing in robots to make shoes, to making robots.

This progression is natural; in fact there is some evidence that China has been relatively slow to upgrade (actually it has held its competitive edge in textiles, apparel and footwear longer than expected). It is the sheer scale of China's economy that is significant. According to Deutsche Bank, China has become a bigger export market for Asian countries than the US and EU combined. This has obvious regional geopolitical implications.

There's more to this story than China's heft. Naturally, as it gets better, it would need to less imports in order to generate exports (ie., its domestic value added will rise). China's real import volumes (after adjusting for the fall in oil prices and other commodities) have slowed dramatically from almost 20% to just 4% annually in the last two years. The IMF is especially concerned about the ramifications for global growth. Chinese 'rebalancing' could make the country a less enthusiastic importer and an even more awesome exporter.

This is bad news for its regional partners. Obviously some countries will do better than others in China's future economy (those selling cheese or healthcare to China might do better than capital goods or iron). A separate analysis from Goldman Sachs calculates that the Asian GDP 'trade multiplier' ratio to China's growth has fallen drastically, from 3.5 to 1.0 since 2009, as China substitutes high-tech components from Japan and Korea with domestic ones. Again, look for geopolitical consequences here.

The Germans too are rethinking their stakes in China's industrial upgrading. Its Mittelstand machinery firms have long been welcoming to Chinese acquirers and Germany has promoted a grand technical partnership, with Beijing noticeably friendlier than the Sino-American confab. Every week, on average, sees one new Chinese bid for German machinery companies. Now German owners, managers and unions are questioning this arrangement:'We completely open our markets, but the Chinese don't open theirs to us'. As Washington has learned, China has no intention to offer reciprocity in investment treaties.

Berlin’s outspoken ambassador argues trenchantly over what he calls 'AITTAC': asymmetric investment, technology transfer, and asymmetric competition. European businesses are finding China 'increasingly hostile' according to a recent survey. In an awkward twist, Angela Merkel is visiting China this week as her cabinet desperately tries to orchestrate a European counter-offer for KUKA. Foreigners are negotiating temporary market access with Beijing but at the cost of permanently losing strategic franchises. Robotically selling companies like KUKA to China looks injudicious — if not plain kooky.